MB 664 UVG-TAMU May Business Business Finance MB-664 DuPont Model

MB 664 UVG-TAMU May Profit Improvement

MB 664 UVG-TAMU May Du Pont Formula ROA can be broken down into margin and turnover ROA can be broken down into margin and turnover Gain insight into planning for profit improvement Gain insight into planning for profit improvement Improve margin Improve margin Improve turnover Improve turnover Improve both! Improve both!

MB 664 UVG-TAMU May Improve Margin Reducing expenses Reducing expenses  Using less costly materials  Automation to improve productivity  Review fixed costs (advertising, R&D, management development programs, etc.) Raising prices Raising prices  Requires pricing power  Also requires brand loyalty  Easier for firms with unique high-quality goods or services

MB 664 UVG-TAMU May Improve Turnover Increase sales while holding investment in assets relatively constant Increase sales while holding investment in assets relatively constant  Dispose of obsolete and redundant assets  Speed up collections of receivables  Evaluate credit terms and policies  Identify unused fixed assets Use idle cash to repay outstanding debts or invest in profit-producing activities Use idle cash to repay outstanding debts or invest in profit-producing activities

MB 664 UVG-TAMU May Cost of goods sold Selling expenses Administrative expenses Cash Accounts receivable Inventories Marketable securities Other current assets Land Buildings Machinery Equipment

MB 664 UVG-TAMU May Cost of goods sold Selling expenses Administrative expenses Cash Accounts receivable Inventories Marketable securities Other current assets Land Buildings Machinery Equipment Total cost Current assets Fixed assets

MB 664 UVG-TAMU May Cost of goods sold Selling expenses Administrative expenses Cash Accounts receivable Inventories Marketable securities Other current assets Land Buildings Machinery Equipment Sales Total cost Current assets Fixed assets Net income Total assets

MB 664 UVG-TAMU May Cost of goods sold Selling expenses Administrative expenses Cash Accounts receivable Inventories Marketable securities Other current assets Land Buildings Machinery Equipment Sales Total cost Current assets Fixed assets Net profit margin Total asset turnover Total assets Sales ÷ ÷ Net income Sales

MB 664 UVG-TAMU May Cost of goods sold Selling expenses Administrative expenses Cash Accounts receivable Inventories Marketable securities Other current assets Land Buildings Machinery Equipment Sales Total cost Current assets Fixed assets Net profit margin Total asset turnover Total assets Sales ÷ ÷ Net income Sales ROA ×

MB 664 UVG-TAMU May Cost of goods sold Selling expenses Administrative expenses Cash Accounts receivable Inventories Marketable securities Other current assets Land Buildings Machinery Equipment Sales Total cost Current assets Fixed assets Net profit margin Total asset turnover Total assets Sales ÷ ÷ Net income Sales ROA × The Du Pont formula

MB 664 UVG-TAMU May Modified Du Pont Formula Use of borrowed funds can magnify returns to equity. To see this Consider the following definitions: ROE = Net income ÷ Equity or ROE = (Net income ÷ Total assets) × (Total assets ÷ Equity) or ROE = ROA × Equity multiplier where: Equity multiplier = Total assets ÷ Equity or Equity multiplier = 1 ÷ (1 – Debt ratio)

MB 664 UVG-TAMU May An Example Assume the following values: Sales (S) = $50,000 Net income (NI)= $18,000 Total assets (TA) = $100,000 Equity (E) = $45,000 Using the previous definitions: ROE = NI ÷ E = $18,000 ÷ $45,000 = 40% Equity multiplier = TA ÷ E = $100,000 ÷ $45,000 = 2.22 or Equity multiplier = 1 ÷ (1 – Debt ÷ TA) = 1 ÷ (1 –.55) = 2.22 ROE = NI ÷ TA × Equity multiplier = 18% × 2.22 = 40%

MB 664 UVG-TAMU May Continuation of Example If the firm used only equity to fund its operation, the ROE and ROA would be identical, or: ROE = NI ÷ E = $18,000 ÷ $100,000 = 18% ROA = NI ÷ TA = $18,000 ÷ $100,000 = 18% However, 45% of the firm’s capital was supplied by creditors, so: Equity multiplier = 1 ÷ (1 – Debt ÷ TA) = 1 ÷ (1 –.55) = 2.22 ROE = NI ÷ TA × Equity multiplier = 18% × 2.22 = 40% This illustrates the potential benefits to the use of leverage.

MB 664 UVG-TAMU May Another Example Consider two firms each having $800,000 in total assets but one firm having debt of $400,000, or Firm A Firm B Total assets$800,000$800,000 Total debt 0 400,000 Equity 800, ,000 Each firm has an operating income or EBIT of $300,000 but firm B has interest expenses of $40,000, so: Operating income$300,000$300,000 Interest expense 0 40,000 Profit before taxes 300, ,000 Taxes at 30% 90,000 78,000 Net Income$210,000$182,000

MB 664 UVG-TAMU May Continuation of Example The rate of return on equity for these two firms therefore would be: Firm A Firm B Total assets$800,000$800,000 Total debt 0 400,000 Equity 800, ,000 Net Income$210,000$182,000 ROE 26.25% 45.5% Conclusion: Although the absence of debt allows firm A to register higher profit after taxes, the owner(s) of firm B earn a significantly higher return on equity capital invested in the firm.

MB 664 UVG-TAMU May DuPont formula Summary Because it links several critical ratios, the DuPont formula allows you to examine how a firm generates its ROE. NI = net income NPM = net profit margin = NI ÷ sales TA = total assets EM = equity multiplier = 1 ÷ (1 – debt ratio) TAT = total asset turnover = sales ÷ TA ROE = NPM × TAT × EM or ROE = (NI ÷ TA) × EM

MB 664 UVG-TAMU May DuPont formula Summary Because it links several critical ratios, the DuPont formula allows you to examine how a firm generates its ROE. NI = $18,000 NPM = net profit margin = NI ÷ S = 0.36 TA = $100,000 EM = equity multiplier = 1 ÷ (1 – debt ratio) = 2.22 TAT = total asset turnover = S ÷ TA = 0.5 ROE = NPM × TAT × EM =.36 ×.5 × 2.22 =.40 or ROE = (NI ÷ TA) × EM =.18 × 2.22 =.40

MB 664 UVG-TAMU May Analyzing DuPont formula A firm is said to be in a sound financial condition if: 1.It has a high net profit margin (NPM), which signals strong operating management. 2.It has a high total asset turnover (TAT), which signals strong asset management, 3.It has a low equity multiplier (EM), which signals strong capital management in the presence of low and stable cost of debt capital.